Professional Documents
Culture Documents
FX and Rates Strategists, Asia ex-Japan Craig Chan craig.chan@nomura.com See Appendix A-1 +65 6433 6106
for analyst certification, important Prateek Gupta prateek.gupta@nomura.com disclosures and the status of +65 6433 6197 non-US analysts.
Vivek Rajpal vivek.rajpal@nomura.com +91 22 4037 4438
Prateek Gupta prateek.gupta@nomura.com +65 6433 6197 Wee Choon Teo weechoon.teo@nomura.com +65 6433 6107
Nomura
15 March 2013
Contents
Introduction Symptoms of financial risks 1. Rapid build-up of leverage 2. Rapid asset price inflation 3. Decline of potential growth Identifying the risks Government finances Financial sector conditions Household sector Corporate sector The linkage of risks and moral hazard Endgame: Base case and risk scenario Base case Risk scenario Appendices Appendix 1: Five rounds of trust company regulation Appendix 2: Trust companies have grabbed the headlines Appendix 3: Forecast summary References Recent Asia Special Reports 3 4 4 9 11 15 15 17 21 21 22 23 23 24 26 26 27 28 29 30
15 March 2013
Introduction
The Chinese government has in recent months sent a number of unusually strong signals that it is concerned about financial risks in the economy. At Decembers Central Economic Working Conference, the new generation of leaders stated the need to defend the bottom line of preventing [a] systemic financial crisis. At its Q4 2012 monetary policy committee meeting, the Peoples Bank of China (PBoC) decided to make controlling risks a top policy objective. Then on 31 December, the Ministry of Finance, the National Development and Reform Commission (NDRC), the PBoC and the China Banking Regulatory Commission (CBRC) issued a joint statement on one of the most pressing issues facing Chinas authorities the need to crack down on improper fundraising activities by local governments. The government lowered the M2 growth target to 13% in 2013 from 14% in 2012 at the National Peoples Congress in March. Government concerns have been echoed by warnings from within the financial industry as well as external sources. Bank of China CEO Xiao Gang, writing in the China Daily (12 October 2012, Regulating shadow banking), openly criticised the common bank practice of relying on a non-transparent capital pool to manage wealth-management products and accused them of running a Ponzi game. In its October 2012 Global Financial Stability Report (GFSR) the IMF highlighted Chinas rising financial risks. As we illustrate in this report, there has been a substantial amount of negative news related to new financial products especially trust products and the intensity of such coverage has picked up since late 2012. Nonetheless, we believe the true extent of financial risks in China is not fully appreciated by investors. Fears of a hard landing sent the MSCI China index down to 51.63 in the summer of 2012, but the subsequent economic recovery seems to have alleviated such fears with the index up some 20% since then (Figure 1). The consensus forecast expects a sustainable recovery of GDP growth from 7.8% in 2012 to 8.1% in 2013 and 8.0% in 2014. The market has turned from being very bearish on Chinas outlook six months ago to being quite optimistic. So is the market underestimating the financial risks in China or is the government overalarmed? We believe China faces rising risks of a systemic financial crisis and that the government needs to take action quickly to contain such risks. We assume it will do so in H1 2013 and consequently we expect GDP growth to slow to 7.3% y-o-y in H2 from 8.1% in H1 (Consensus is for growth of around 8% through 2013; Figure 2). If a loose policy stance is maintained and these risks are not brought under control, strong growth of above 8% in 2013 is possible, but that would heighten the risks of high inflation and a financial crisis in 2014. We elaborate our concerns in this report and illustrate them via three common symptoms that have preceded major financial crises elsewhere: 1) high leverage; 2) the rapid rise of asset prices; and 3) a decline of potential growth. Chinas economy already exhibits these symptoms. We discuss financial conditions in the public, financial, corporate and household sectors, and identify the risks that are building for local government financing vehicles, property developers, trust companies and credit guarantee companies. We conclude by laying out our views on the potential triggers that could turn these risks into real threats to the economy.
Fig. 1: MSCI China index
Index 70
The government has sent strong signals that it is concerned about financial risks
but since Q4 2012 the market seems to have discounted them as growth recovers
We believe the market is underestimating the risks in China and that growth will slow in H2 2013
We elaborate our concerns, highlight where the risks lie and discuss how they might play out
Consensus forecast
Nomura forecast Actual
8.5
65 8.0 60
7.5
55
50 Mar-12
Jun-12
Sep-12
Dec-12
Mar-13
7.0 1Q12
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13
4Q13
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A rise in leverage has preceded many major financial crises in the past
Some argue leverage is not as high as in developed countries such as Japan, so there is no need to worry
200
135
150
100
115
50
95
1997 2000 2003 2006 2009 2012
Spain (2011)
Japan (1989)
US (2007)
Source: IMF, World Bank and Nomura Global Economics. We believe comparing the level of leverage across countries is misleading
However, we believe it is misleading to compare the level of leverage in China to that of developed economies. First of all, the average DCG ratio for OECD countries should not be taken as a healthy benchmark as many developed economies are in debt crises it makes little sense to argue that a person standing close to a cliffs edge is safe because hes standing so much higher than those who have already fallen off it. Neither does it make sense to compare
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the level of leverage in China today with that in Japan 25 years ago as it fails to take into account the country-specific conditions of the different eras, such as, for example, the development of financial markets and the level of financial assets in the economy. A better approach to compare different countries' experience is to assess not only the level of leverage, but also the change in leverage. A high but stable level of leverage does not necessarily suggest high risks, but a rapid build-up of leverage (i.e., where credit growth outpaces GDP growth) should make both investors and regulators vigilant. In that sense we need to worry about China. Its leverage, measured by the DCG ratio, rose quickly from 121% of GDP in 2008 to 155% in 2012 (Figure 5). Looking at China's history over the last 30 years, there was a similar build-up of leverage in the 1990s which made the whole banking sector insolvent. After Deng Xiaopings famous Southern tour in 1992, China began an investment boom which ultimately led to economic overheating and high inflation. Leverage rose quickly, as the DCG ratio climbed 24 percentage points (pp) from 1994 to 1998. Policy had to tighten to contain inflation, and then the Asian financial crisis amplified the cycle as the government pushed expansionary policies to offset a decline in exports. Consequently, China went through a long and painful deleveraging process from 1998 to 2004. According to the World Bank, the non-performing loan (NPL) ratio in China's banking sector rose to a high of 29.8% in 2001 and the government had to restructure the major banks by injecting public funds and removing bad loans to asset management companies.
The change of leverage is a leading indicator for crises
Chinas leverage rose by 34% of GDP in five years a worrying sign given its history
Leverage in Japan, the EU and the US rose by around 30% of GDP in the five years before entering a crisis
Fig. 5: Chinas domestic credit to GDP ratio and its change based on a five-year rolling window
% of GDP 160 Domestic credit/GDP Changes (pp), rhs pp 40 30 140 20 10 120 0
Japan (1985-89)
China (2008-12)
US (2003-07)
US (1995-99)
30
15
100
-10 -20
-15
-30
Note: The gray line shows the change in the DCG ratio in a given year from five years earlier e.g., the reading in 2012 is 34pp because the leverage ratio rose to 155% of GDP in 2012 from 121% of GDP in 2008. Source: IMF, CEIC and Nomura Global Economics.
Note: Year t refers to 1989 in Japan, 1999 and 2007 in the US and 2012 in China. The lines show how fast leverage built up e.g., the line for China shows its DCG level declined by 20pp from 2004 to 2008, then increased by 34pp from 2008 to 2012. Source: IMF, CEIC and Nomura Global Economics.
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In the European Union, the DCG ratio rose by 26% of GDP over the period 2006-10, from 134% to 160% (Figure 9).
While the 5-30 rule may provide a useful handle as a financial crisis indicator, of course there is room for the DCG ratio to grow by more than 30% of GDP over the timeframe in Thailand, for example, the DCG ratio rose 46% of GDP from 131% in 1994 to 177% in 1998 (Figure 9). Still, given the size of the economy, we believe it more appropriate to compare China to Europe, Japan and the US. Moreover, China's own experience in the 1990s suggests that the DCG rising by 34% of GDP in five years is a dangerous extension of credit the infamous GITIC (Guangdong International Trust and Investment Corporation) default happened in 1998, when the DCG ratio rose to 110% from 86% in 1994.
Fig. 7: Domestic credit-to-GDP and its change, five-year rolling window Japan
% of GDP 250 Domestic credit/GDP Changes (pp), rhs pp 35
230
210
30
25
30 220 20
190
170
20
10
15
190
150
130 1974 1978 1982 1986 1990 1994
10
5
-10
Note: Nikkei 225 stock index peaked in 1989 when the asset bubble burst. Source: IMF, CEIC and Nomura Global Economics. Fig. 9: Domestic credit to GDP and its change, five-year rolling window EU
% of GDP 160
Domestic credit/GDP Changes (pp), rhs 140 20 pp 30
Note: NYSE composite index peaked in 2000 and 2007 respectively when the IT bubble and financial crisis broke out. Source: IMF, CEIC and Nomura Global Economics. Fig. 10: Domestic credit to GDP and its change, five-year rolling window Thailand
% of GDP 200 Domestic credit/GDP Changes (pp), rhs pp 70
170
40
10
-20
-50
Note: The European debt crisis broke out in 2009. Source: IMF, CEIC and Nomura Global Economics.
Note: Asia crisis broke out in 1997. Source: IMF, CEIC and Nomura Global Economics. Actual build-up of credit may be higher than official data suggest
The rise of leverage in China is clearly troublesome, but the problem actually extends beyond that implied by the DCG ratio. The DCG ratio only captures credit provided by the official banking system and does not include credit supplied through the bond and equity markets, or the shadow banking system (i.e., lending activity that does not show up on bank balance sheets is less transparent and less subject to supervision, regulation and capital requirements). Credit extension outside the banking system has become increasingly important since 2008 as the
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government tightened regulations on bank lending. The 20% reserve ratio requirement on bank deposits, earning a very low rate of interest, smacks of financial repression and has most likely encouraged the disintermediation.
Fig. 11: Total social financing and its main components (flow)
(RMB bn) TSF estimated by Nomura Government bonds Underground lending TSF released by the PBC New loans Trust loans Corporate bonds Short-term bill NF equity financing & entrusted loans Others 2004 3328 326 140 2863 2406 0 47 -29 379 61 2005 3438 292 145 3001 2496 0 201 2 230 71 2006 4701 240 191 4270 3298 83 231 150 423 85 2007 7993 1793 233 5966 4019 170 229 670 770 108 2008 7510 234 296 6980 5099 315 552 107 759 150 2009 15388 867 610 13911 10521 436 1237 461 1013 243 2010 15494 986 489 14019 8430 386 1106 2335 1454 308 2011 14050 755 466 12829 8043 203 1366 1027 1734 455 2012 17068 778 529 15761 9120 1289 2250 1050 1535 518
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Banker acceptance bills. These are a promised future payment issued by firms that are accepted and guaranteed by commercial banks. After acceptance, the bill becomes an unconditional liability of the bank, but the holder can sell (exchange) it for cash at a discount to a buyer who is willing to wait until the maturity date. Banker acceptances are frequently used in money market funds. Equity financing. Equity market IPOs have slowed in recent years due to bearish market conditions.
or underground financing
TSF measures credit growth better as most has taken place outside the banking system in recent years
% y-o-y 15
190
30
13
25
11
160
20
130
15
100
2004 2006 2008 2010 2012
10 Dec-04
Dec-06
Dec-08
Dec-10
5 Dec-12
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The equity market does not pose a threat in China at this stage, in our view
An appropriate price index shows Chinas property prices rose more than those in the US housing bubble
Fig. 15: Average land sale price and property sale price
2003=100 600
China
US: CS housing index
Land price 500 Property price
250
400
200
100 Dec-00
Dec-03
Dec-06
Dec-09
Dec-12
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
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The government obviously recognises the risks in the property sector. It has introduced a series of progressively tighter policies to contain property prices over the past several years, including raising the down-payment ratio for second-home purchases, limiting home purchases by nonlocal families, applying stricter criteria when levying land value-added tax from real-estate developers, prohibiting mortgages for a third home (or higher) purchases, and limiting bank lending to real estate developers. The pattern has been for house prices to initially dip after tightening policies are introduced, then to rebound, which suggests that the risks have not been mitigated. In early September 2012, land auctions suddenly turned hot again as large developers many of them state-owned enterprises pushed up bidding. The Shanghai Stock Exchange Property Index rebounded sharply by 29% from August 2012 to January 2013. Fixed asset investment growth in the housing sector also picked up. The recovery in the housing market is not, in our view, a reflection of improved underlying fundamentals, as inventory on a national level remains high (Figure 16). Another round of measures, including the 20% capital gains tax, was implemented on 1 March and M2 growth will likely fall from 15.2% in February as the government has set its target at 13% for 2013, which should pose downside risks to both property prices and investment (Figure 17).
Fig. 16: Floor space started and sold
Square meter mn (12 month rolling sum basis) 2,000
Property prices and investments were weak, but have picked up again recently
leading to another round of tightening and downside risks to the property sector
M2 growth, rhs
1,600 Floor space started Floor space sold 1,200
800
400
0
0 Feb-01
Feb-04
Feb-07
Feb-10
Feb-13
-3 Feb-05
Feb-07
Feb-09
Feb-11
10
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driven partly by a productivity slowdown, as seen in Japan, Europe and the US before they entered crises
which fell before crises in Japan, the US, Europe and Thailand
Some may wonder why global export market share worked well in predicting financial crises given the fact that not all of the above economies are export-dependent; the US, for example, is much more driven by domestic than external demand. We believe the reason is because changes in export market share are a good indicator for changes in competitiveness and productivity of the overall manufacturing industry. The latest economic research in academia shows that, in a given economy, more productive firms move across borders to compete in global markets (Melitz and Redding, 2012; Manova and Zhang, 2012). Therefore, if there is a broad-based productivity slowdown, exporters' market share in the global market would shrink even if exports are not a pillar of growth in that economy. The market-share analysis shows that China gained competitiveness rapidly before 2010, but progress has since come to a halt. We do not have the global trade data for full-year 2012 yet, but taking Chinas market share in the US as a proxy it appears to have peaked in 2010 (Figure 22). This suggests that the rapid productivity growth after WTO accession has likely ended. For labour intensive industries such as footwear and apparel, Chinese exporters market share has fallen (Figure 23), which has offset the rising share of capital intensive goods.
Market share of Chinese exporters rose sharply before 2010, but has since stalled
11
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12
10
11
10
9
6
8
4 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011
7 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Note: Nikkei 225 stock index peaked in 1989 when the asset bubble burst. Source: IMF, CEIC and Nomura Global Economics. Fig. 20: Spains market share in global export market
% of total 2.2
Note: NYSE composite index peaked in 2007 ahead of the global financial crisis. Source: IMF, CEIC and Nomura Global Economics. Fig. 21: Thailands market share in global export market
% of total
1.4
2.1
1.2
2.0
1.0
1.9
0.8
1.8
0.6
1.7
0.4
0.2
1983 1987 1991 1995 1999 2003 2007 2011
Note: The European debt crisis broke out in 2009. Source: IMF, CEIC and Nomura Global Economics. Fig. 22: Chinas market share in US market
Note: Asia crisis broke out in 1997. Source: IMF, CEIC and Nomura Global Economics. Fig. 23: Chinas market share in US: labour intensive vs capital intensive goods
% 80 Labour intensive products, lhs % 55
% of total 25
20
64 37
15
56 28
10
48
19
40 Nov-00
Nov-03
Nov-06
Nov-09
10 Nov-12
Source: CEIC and Nomura Global Economics. Note: total US imports excluded oil imports.
Note: 12m moving average; for labour-intensive goods we cite footwear; while for capital-intensive goods we cite telecom and sound equipment. Source: CEIC and Nomura Global Economics.
12
15 March 2013
We believe China's global export market share likely peaked in 2012. The three main sources of China's competitiveness demographics, an undervalued currency and reform dividends have all weakened since 2008. On the demographics side, trends that were working in Chinas favour before 2008 have now turned against it. The demand supply ratio in the urban labour market is arguably the best indicator of wider labour market conditions in China. The ratio was persistently below 1 before 2009, suggesting the labour market was over-supplied, mostly due to the large influx of migrant workers from inland rural areas. But in 2009 the trend reversed. The ratio climbed above 1 in Q4 2009 and remained there for 12 consecutive quarters. Even when GDP growth slowed to 7.4% in Q3 2012, the ratio remained above 1 (Figure 24), which suggests to us that the potential growth rate has likely slowed to 7.0-7.5%. Working-age population. The United Nations projected that Chinas working-age population would peak in 2015. This projection has been widely cited in China and taken as a working assumption for many policymakers and researchers, but the data show that Chinas working-age population began to decline in 2012 (Figure 25), having grown for at least the past 20 years.
We believe Chinas market share will fall as the labour force starts to contract
On the currency side, RMB has appreciated by 22.9% against the US dollar and 25.7% in relative effective exchange rate (REER) terms between 2005 and 2012. Its appreciation against some emerging market currencies has been particularly significant for example, one RMB could be exchanged for IDR1,191 in 2005, but had strengthened 25.4% to IDR1493 in 2012 (Figure 26). During the same period, RMB appreciated by 57.4% and 56.8%, respectively, against the Indian rupee and the Mexican peso. The real economic effects of the labour market tightening and currency strength caused the wage differential between Chinese workers and Indonesian workers to widen significantly over the same period. The average wage in China was about twice that in Indonesia in 2000, but by 2011 this had risen to 3.5 times (Figure 27). Over the period of 2000 and 2011, cumulative wage growth in China was 473.7%, much higher than 238.6% in Indonesia, 137.2% in India and 46.3% in Mexico. Can productivity growth in China offset the rising wage differential between China and emerging markets such as Indonesia? We believe it is unlikely. The slowdown in reform momentum since WTO accession in 2001 is hurting China's productivity growth today. There is widespread complaint in China's policy circles and the media over the slow progress of major reforms. The government has relied heavily on Keynesian-style infrastructure investments to boost growth and avoided difficult structural reforms such as moving to a fully market-based monetary policy framework and opening up the service sector that is monopolised by the SOEs. As the three main sources of Chinas competitiveness run out of steam, China is no longer as attractive to foreign investors. Indeed, FDI into China used to grow faster than FDI to other developing countries, but this trend is changing (Figure 28). A recent survey by Japan Bank for International Cooperation shows China's popularity among Japanese companies declined sharply in 2012 while Indonesia's popularity rose (Figure 29). This suggests FDI growth in China may face downward pressure in the years ahead as well. FDI is also a leading indicator for exports; as China increasingly relies on public investment over private and foreign investment, its productivity faces downside risks.
13
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Fig. 24: China labour demand supply ratio and GDP growth
Ratio 1.2 Labour demand/supply ratio % y-o-y 16
% y-o-y
15 14 13
3
1.0 12
12 11
2
0.9 10
1
0.8 8
10
9
0.7 Dec-03
Dec-06
Dec-09
6 Dec-12
-1
India
China
Indonesia
Mexico
6,000
5,000 4,000
130
3,000
120 110
100 90 Dec-06
2,000 1,000 0
Dec-08 Dec-10 Dec-12
2000
2011
Note: For India, the wage is rural wage level. Source: CEIC and Nomura Global Economics.
40
30 20 10 0
-5
-10 -15 -20 -25 2008 2009 2010 2011 2012
(FY)
Source: Japan Bank for International Cooperation and Nomura Global Economics.
14
15 March 2013
Government finances
The central government is clearly in good financial condition. The public debt-to-GDP ratio was only 15.2% in 2011, while foreign currency-denominated debt only accounted for 0.9% of total central government debt. The fiscal balance has registered a deficit in recent years, but the deficit has been limited to below 3% of GDP. Moreover, on the asset side, the government holds USD3.3trn of FX reserves, while the value of SOE assets reached RMB85.37trn in December 2011. Financial conditions in the general public sector are not nearly as favourable. There is no official consolidated balance sheet for the central and local government. The Chinese Academy of Social Science (CASS), an official government think-tank, published its estimate of China's consolidated public balance sheet for 2010, including the central and local governments, as well as the SOEs (Li and Zhang, 2012). The CASS study claims that the public sector in China should be considered solvent because of potential revenue from selling natural resources such as land, and privatisation of SOEs (Figure 30). CASS estimates total public sector assets of RMB142.3trn in 2010 against total liabilities of just RMB72.7trn. On the asset side, however, the two major items that could be sold to pay down debt are natural resources (RMB44.3trn) and SOEs (financial and non-financial, combined, at RMB67.3trn). Local governments have relied heavily on land sales as a major source of debt financing in recent years. Privatisation of the SOEs has not yet been utilised as a major source of funds, but we expect it will likely take the spotlight in coming years.
Fig. 30: Chinas public sector balance sheet, 2010
Total Assets Government deposit in the PBoC Reserve asset Natual resources including land SOA in administrative public entities SOA in non-financial enterprises SOA in financial institutions SOA in national social security fund RMB trn 2.4 19.7 44.3 7.8 59.1 8.2 0.8 Total Liabilities Central government's domestic debt Sovereign debt Local government debt (excluding LGFV) Debt of LGFV Debt of non-financial SOEs (excluding LGFV) Debt of policy banks NPL of banks Potential debt from solving NPL Implicit debt from pension fund Total assets 142.3 Total liabilities Public sector net assets RMB trn 6.7 2.3 5.8 9.0 35.6 5.2 0.4 4.2 3.5 72.7 69.6
Source: CASS.
15
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Fig. 31: Land sales revenue and urban construction bond issuance
RMB bn 3500 RMB bn
1400
3000
2500 2000 1500 1000 500
1200
1000
100
80
0
2006 2007 2008 2009 2010 2011 2012
0
2004 2006 2008 2010 2012
16
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a lack of transparency
17
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The CBRC has asked banks to clean up the fund pools and match WMPs with specific projects. Links to risky assets. Many WMPs are linked to stocks, bonds and exchange rates (Figure 36). About 36% of WMPs are reportedly related to trusts (Figure 37). As we discuss below, trust products may well be the weakest link in the financial leverage chain. The boom of WMPs has only happened in the past several years and has not been tested by a downturn in the credit cycle so far there have only been a limited number of default cases in the trust sector, but we believe the likelihood is high that there will be more in the years ahead.
and often have links to risky assets, such as trusts
In theory, WMPs do not add credit risk to the banks, as information is disclosed so that investors can judge their investment risk. In reality, however, there may be implicit credit risk for the banks. A very recent example involving Huaxia Bank demonstrates this after an employee sold a WMP which subsequently defaulted. It was discovered that the salesman was not authorized by the bank to sell it and many investors then claimed that this was fraud and demanded Huaxia Bank pay for their losses. The losses were eventually paid, though the source of the funds was not clear. Nonetheless, this example illustrates that it is not 100% clear whether the banks can walk away from credit risk related to WMPs. In the case of default, there is every chance that investors will become embroiled in lengthy disputes with the bank that sold them the product. Another significant loan category amounting to RMB8.2trn, or 13.1% of total loans outstanding is mortgage lending (Figure 38). However, we believe mortgage loans do not constitute a major risk to banks because: 1) down-payment requirements are high 30% for first-time homebuyers, 60% for a second house, while mortgages are not an option for third houses or more; 2) 30% of mortgage loans were made before 2009, when housing prices were 33% lower than current levels. Therefore, even if housing prices were to fall sharply, by say 30%, the net impact on bank mortgage loans would not be too significant.
%
LGFVs
16 14
Mortgages
12 10
RMB7.9trn
8
RMB3.8trn
6
4
Property developers
2 0 Dec-04
Dec-06
Dec-08
Dec-10
Dec-12
Note: Data is for Q3 2012. Source: CEIC and Nomura Global Economics.
18
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16000
12-24m 3-6m
16000
12000
1m
12000
8000
8000
4000
4000
0
1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 1H12 2H12
2H11
2013*
0
1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 1H12 2H12
2H11
Note: 2013 data refers to new issuance in January and February. Source: WIND and Nomura Global Economics.
Note: 2013 data refers to new issuance by January and February. Source: WIND and Nomura Global Economics.
16000
QDII 12000 Trust Others
30%
8000
55% 15%
4000
0
1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 1H12 2H12
2H11
2013*
Note: 2013 data refers to new issuance by January and February. Source: WIND and Nomura Global Economics.
AUM at the trust companies rose by 5.8x in five years it is bigger than the insurance sector
19
2013*
15 March 2013
As mentioned before, property and infrastructure projects are the main destinations for funds raised from trust companies (Figure 40). Official data show that in 2012 around 8% of trust funds went to property investment, 28% to infrastructure and 35% to industrial and commercial companies. Information is not provided on where the remaining funds are invested. We think a large part of it may have gone to property-related projects as well. The business of trust companies in China is highly cyclical. Indeed, trust companies have always been utilised as a channel of alternative financing banks are traditionally heavily regulated, yet trust companies could work through loopholes in the system to offer credit supply to money-hungry firms that do not have access to banks. In that sense, trust companies in China work exactly as shadow banks. History suggests we need to be very cautious about the boom in the trust sector There have been five boom-and-bust cycles in the trust sector since 1980. Each time the boom was associated with an economic upturn and the bust amplified the deleveraging process and damaged the economy (see Appendix 1).
Fig. 39: Assets under management at non-bank financial sectors
RMB bn 7,000 Mutual funds
The trust sector is highly cyclical and typical of the shadow banking sector
Five cycles that suggest a trust sector boom usually leads to a bust
RMB bn 1,400
Insurance Trust
6,000
5,000 4,000 3,000 2,000 1,000
1,200 1,000 800 600 400 200 0 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12
0
2007 2008 2009 2010 2011 2012
Source: CEIC and Nomura Global Economics. The current boom may be close to its end
We believe Chinas trust sector is going through its sixth boom-bust cycle with the end of the boom nearing. The trust companies have received a lot of negative press coverage since mid2012 (see Appendix 2), with reports that many trust products were close to default yet they have managed to somehow survive. When monetary policy and regulations on trust companies tighten, the risks in this sector will eventually emerge and may be difficult for local governments to contain. CGCs also face high risks if the economic cycle turns down. These are also not well regulated and many are reportedly engaged in underground lending. There were several high-profile fraud cases reported in 2011 and 2012 in this sector, including the case of Zhong Dan, which was one of the top private CGCs in China. In May 2012, it went into bankruptcy as its owner disappeared with his clients' money after reportedly running a heavily leveraged business empire that ran into trouble once monetary policy was tightened early in the year. The total loss to clients was RMB1.3bn. The CGCs are not transparent and there is very limited information about the current state of this sector, but the Zhong Dan case suggests they may be subject to high credit risks in the next round of policy tightening.
20
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Household sector
China's household sector is in good financial condition, with total household debt at only RMB10.4trn at end-2012, or 20.1% of GDP. Mortgage loans outstanding were RMB8.1trn, or 15.6% of GDP (Figure 41). The low leverage of the household sector is in large part because of stringent requirements on down-payments and a relatively low mortgage rate, as well as policy tightening in the property sector in recent years. A household borrowing culture has only recently started to take hold. The household saving rate remains high, and home ownership is high as well. The household sector has so far proven rather resilient to equity price shocks. The Shanghai A share index plunged from 5,954 in 2007 to 1,820 in 2008, yet retail sales growth remained solid at 21.6% in 2008 from 16.8 in 2007 (Figure 42). Low leverage in the household sector must in large part be recognised as a significant factor in the muted reaction. Financial market liberalisation has led to some new risks to household balance sheets, but we believe they are manageable. We estimate the total amount of corporate bonds and trust products outstanding by the end of 2012 was RMB8.5trn, with most held by financial institutions rather than household. Moreover, total household deposits are RMB41.1trn. Combined with limited leverage, we therefore believe the impact of a potential default on household balance sheets would be manageable.
The household sector is in good financial condition
Low household leverage means consumption has been resilient to equity price shocks
% of GDP
24 Mortgage loans 20 Total household debt 16
% y-o-y
23
21
5,800
19
4,600
12
17
3,400
15
2,200
13 Dec-06
Jun-07
Dec-07
Jun-08
1,000 Dec-08
Corporate sector
Property developers are also leveraging up. There are two sources of data on property developers' financial conditions: the financial reports of listed companies, which show the debtto-asset ratio had risen to 71% by 2012, from 40% in 2009 (Figure 43). The other is data from the National Bureau of Statistics (NBS) data on the source of funds for property investment by all property developers, which shows that they rely increasingly heavily on funding from outside the banks (Figure 44). We believe the risks to property developers and LGFVs are tied together. If the property market cools, developers would be expected to shy away from land sales and the LGFVs would face severe financing problems. Actually, some LGFVs are property developers themselves. For instance, in Changzhou, the Wujin Urban Construction Company owns a property developer which contributes most of the funding to its infrastructure projects. Leverage conditions in the overall industrial sector seem stable, as the debt-to-asset ratio remains around 58% in recent years. However, it is worth noting that profitability has fallen in recent years, which shows that they may be becoming more vulnerable to a shock.
Property developers face risks given their high leverage
Leverage of the whole industrial sector is stable, but profitability has fallen
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% of asset 80 70
83
60
50 40
81
30
20
79
77
10
0
2009 2010 2011 2012
The moral hazard issue leads to a transfer of wealth from the general public to the rich
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Consensus believes the new government has to keep policy loose in its first year
We believe the government will tighten because: 1) the risks are high
2) The government may apply lessons learned from other countries failure
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We believe that if the government decides to tighten policy quickly, a few cases of default are likely, but the banks and the government have the capacity to absorb these losses. The question becomes one of burden sharing among the government, the financial sector and investors, but we see little risk of a systemic financial crisis.
Risk scenario
The risk scenario is that the government decides to keep policy loose and tolerate the financial risks in exchange for strong growth in the short term. This is clearly a dangerous choice, but we cannot rule it out given political pressures to maintain strong growth. We acknowledge the fact that this is the first year for the new leaders in office, and that at the recent National Peoples Congress it was decided to keep a growth target of 7.5% rather than cutting it to 7% (the target for the 2011-15 five-year plan). When growth slows to 7.5% or below, we can expect a lot of pressure to loosen policy and deliver another round of fiscal stimulus. If the government does decide to loosen policy further this year, then the risks of a systemic crisis in coming years would rise. We have written before on the risk of an economic hardlanding (see China risks, November 2011), while our proprietary China Stress Index suggests elevated macro risks in the economy (see Nomura's China Stress Index (CSI) - high but stable in Q4, 31 January 2013; Figure 46). Further policy easing could push the leverage ratio and inflation even higher, which would make the eventual deleveraging process more disruptive.
Fig. 45: Domestic credit-to-GDP ratio, Germany and Japan
% of GDP 135 Germany Japan, rhs 101.5 125 235 101.0 115 210 100.5 105 185 100.0 % of GDP 260
102.0
160
99.5 Dec-00
Dec-03
Dec-06
Dec-09
Dec-12
In a systemic crisis scenario, we believe the first link in the system to break would be the credit guarantee companies, the trust companies and the highly leveraged developers without government ties. CGCs and trust companies are highly leveraged, as they have only a limited amount of capital. Once a default occurs in the bond and/or trust market, credit spreads could widen to price in the actual risk premium and we can expect the volume of transactions to shrink quickly. Contagion could quickly spread because many of the risks have become interlinked. It would be difficult for firms to issue new debt without an explicit government guarantee. Without government intervention, the risks would inevitably spread to the banks and the corporate sector. The banks NPL ratios are generally low, partly because the LGFVs had to borrow from the bond and trust markets to repay bank loans. If LGFVs can no longer issue new debt, then NPLs at the banks would likely rise. The same argument applies to the corporate sector as well, particularly the property developers. That said, we doubt the government would allow the shock to be amplified through the above channel, so in this case, we believe a public bailout would be an inevitable eventuality. A bailout on such a scale is not unprecedented in China. In the early 2000s, the government set up four asset management companies (AMCs) and transferred the bad loans from bank balance sheets to them. The operation was financed through the Ministry of Finance. The AMCs still exist and could play an important role in this risk scenario.
CGCs, trust companies and highly leveraged property developers are at most risk
The government would likely bail out the financial sector, as it has in the past
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Of course, there are many forms that a bailout could take. The conventional debt restructuring or debt writedown of bank NPLs, in which investors (including the government as major shareholder) would have to bear the loss. The injection of public funds to recapitalise the banks and transfer NPLs to the AMCs at a discounted price, similar to events in the early 2000s, is also an option. Third, is a potential transfer of central government funds to local governments as a source to allow them to repay their debt, or, fourth, the sale and privatisation of local government assets to repay the debt. We do not have a particularly strong view on which particular option would be the primary model, but we do see an increased likelihood of greater privatisation in the years to come. Many local governments own assets in areas such as public utilities, highways and housing, many of which are the result of fiscal largesse in recent years. It is not hard to imagine local governments being forced to sell such assets at discounted prices as pressure builds. While a bailout could help avoid a complete financial sector meltdown, it would not be enough to kick-start the next growth cycle. In the early 2000s, Chinas economy turned around not because of the bailout, but because of a series of aggressive reforms alongside WTO accession; the high potential for productivity growth given favourable demographic trends; and a huge labour force that migrated to the coastal regions to work. The key to Chinas future is reform, which usually only happens when the pressure to act has built to intense levels. Privatisation at both the state and local level may also help improve productivity. The government may even be forced into other tough reform decisions, such as de facto land privatisation. The economic outlook will depend on how these reforms are conducted, and the end-game will plant the seeds of the next phase of economic development.
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Appendices
Appendix 1: Five rounds of trust company regulation
Round 1: 1985. In 1977 Deng Xiaoping took over the political leadership and began his famous market-oriented reforms. The establishment of China International Trust and Investment Corporation (CITIC) in October 1979 marked the re-emergence of the trust industry in China. Over 1981-82, many new trust companies were established by banks, local governments and government ministries, but their main business was to take deposits or enable interbank lending, either for lending or direct investment in development projects. However, the practice quickly led to an overheating in fixed asset investment and rising inflation. The State Council tightened regulations on the trust industry in September 1985, banning new trust loans and cleaned up existing trust loans. Round 2: 1988. The economic cycle picked up in 1986 and ended in 1988 when the economy overheated. Fixed asset investment growth reached 25.4% and hyper-inflation surged to 20% from 7.8% in 1987. By early 1988, the number of trust companies had increased to around 1,000, of which 745 had received formal approval from the Peoples Bank of China. In August the government controls reduced the number of trust companies to 360. Round 3: June 1993. The economy overheated once more following Deng Xiaopings famous south tour in 1992. One important regulation was the separation of trust and banking businesses. Trust companies were banned from deposit-taking or conducting settlement business and were also excluded from the securities brokerage and underwriting businesses. Round 4: 1998. The financial crisis in East Asia led to a growth slowdown in China and some high profile bankruptcy cases such as Guangdong International Trust Company (GITIC). By 2001, the number of trust companies had fallen to just 59. Round 5: 2007. Amid another period of economic overheating, these were partly triggered by several bankruptcy cases in the trust sector between 2004 and 2006, such as DLong Company and Hainan Huitong Trust and Investment Corporation. In March 2007, the regulators announced that they would apply ratings-based regulations on the trust industry.
Source: Nomura Global Economics.
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Media reports Feb 2012 Mar 2012 May 2012 June 2012 Sep 2012 Nov 2012 Nov 2012 Dec 2012
Risk event SDIC Trust arranged a trust loan of RMB200mn to a company with no income or tax record, and with poor collateral. Jilin Province Trust suffered a loss from a fraud related to one of its trusts worth RMB150mn. Local government in Shandong reportedly asked trust companies to issue trust products for government financing. China Credit Trust's RMB3.0bn mineral energy trust product reportedly faced a high default risk. Zhong Rong International Trust's RMB1.164bn of products related to real estate projects in Ordos faced a high default risk. China Fortune International Trust failed to pay interest on its RMB547mn of trust products. A trust product sold by Huaxia Bank defaulted, which was widely reported in both Chinese and international media. CITIC Trust's RMB1.3bn San Xia Quan Tong Project faced high default risks and failed to make interest payments on time. Qingdao Kaiyue, a RMB300mn trust loan product originated by Zhong Rong International Trust, had difficulty paying investors. The collateral (real estate assets) was auctioned at 60% below the original appraised price. Chaorisolar, a listed solar power company, pledged its equity to eight trust companies. It faces the risk of bankcruptcy and the CEO has disappeared. Trust loans linked to the company face default risks. Pingan Trust's RMB3.6bn project "Jiayuan #25" faces heightened default risk as its Fuzhou property project is far from completion, but the trust repayment date is close. The RMB400mn "golden bull" trust product issued by CCB Trust reportedly suffered a book loss of over 50%. CITIC Trust's RMB710mn real estate project in Qingdao faces a high default risk. The collateral (real estate assets) was auctioned at 40% below the original appraised price Xinhua Trust announced one of its trust loans faces default risks, as the guarantor, Gaoyuan Real Estates, is stuck in a debt crisis. CITIC Trust's RMB1.3bn San Xia Quan Tong Project failed to pay interest on time Tianjin Trust's one trust product was was terminated prematurely in February, less than three months from its issurance, due to interorganizational disputes. An Xin Trust announced a sharp decline in net profit attitributed to shareholders, down by 44.8% from RMB195mn in 2011 to RMB108bn in 2012. The trust product named Chuang FU, issued by Ping'an Trust, was reported to have suffered a loss close to 30%.
Dec 2012
Dec 2012
Dec 2012 Dec 2012 Jan 2013 Jan 2013 Jan 2013 Feb 2013 Mar 2013 Mar 2013
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% y-o-y growth unless otherwise stated Real GDP Consumer prices Core CPI Retail sales (nominal) Fixed-asset investment (nominal, ytd) Industrial production (real) Exports (value) Imports (value) Trade surplus (US$bn) Current account (% of GDP) Fiscal balance (% of GDP) New increased RMB loans (CNY trn) 1-yr bank lending rate (%) 1-yr bank deposit rate (%) Reserve requirement ratio (%) Exchange rate (CNY/USD)
1Q12 8.1 3.8 1.5 14.9 20.9 11.6 7.6 6.9 0.2
2Q12 7.6 2.9 1.3 13.9 20.4 9.5 10.4 6.4 68.4
3Q12 7.4 1.9 1.5 13.5 20.5 9.1 4.4 1.4 79.2
4Q12 7.9 2.1 1.5 14.9 20.6 10.0 9.5 2.8 83.4
1Q13 8.2 2.7 2.0 16.2 21.0 10.8 3.0 7.0 -16.9
2Q13 8.0 3.4 2.1 15.9 21.2 10.5 4.0 8.0 52.9
3Q13 7.4 3.6 2.4 15.5 21.3 9.6 6.0 9.0 70.1
4Q13 7.2 4.5 2.1 15.6 22.0 9.6 6.0 9.0 74.3
2012 7.8 2.6 1.5 14.2 20.6 10.1 7.9 4.4 231.2 2.6 -1.6 8.2 6.00 3.00 20.0 6.29
4.9 6.0 8.3 10.0 180.3 122.0 1.0 -0.4 -1.5 -1.6 9.0 6.50 3.50 20.0 6.15 9.0 6.50 3.50 19.0 6.14
Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table reflects data available as of 15 March 2013. Source: CEIC and Nomura Global Economics.
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References
Martin Neil Baily, Productivity and potential growth in the US and Europe, January 2008, presentation at the European Central Bank. Claudio Borio and Mathias Drehmann (March 2009), Assessing the risk of banking crises revisited, BIS Quarterly Review, p. 25-46. David Brackfield and Joaquim Oliveira Martins, Productivity and the crisis: Revisiting the fundamentals, 11 July 2009. Yongheng Deng, Jing Wu and Hongyu Liu (2013, forthcoming), House Price Index Construction in the Nascent housing market: The Case of China, Journal of Real Estate Finance and Economics. Yongheng Deng, Joseph Gyourko and Jing Wu (September 2012), Land and House Price Measurement in China, NBER Working Paper No. 18403. Federal Reserve Bank of Atlanta, The role of external shocks in the Asian financial crisis, Economic Review, Q2 1999. Jeffrey Frankel and George Saravelos (2011), Can Leading Indicators Assess Country Vulnerability? Evidence from the 2008-09 Global Financial Crisis, Regulatory Policy Program Working Paper RPP-2011-02. Robert J. Gordon, The Slowest Potential Output Growth in U. S. History: Measurement and Interpretation, presented at the Center for the Study of Innovation and Productivity at the Federal Reserve Bank of San Francisco, 2008. Pablo Hernndez de Cos, Mario Izquierdo and Alberto Urtasun, An estimate of the potential growth of the Spanish Economy, Banco de Espana Documentos Ocasionales, N 1104, 2011. Richard C. Koo (14 October 2012), Balance Sheet Recession as the Other-Half of Macroeconomics, Nomura Research Institute. Yang Li, Zhang Xiaojing et al. (June 2012), Chinas Sovereign Balance Sheet and Its Risk Assessment, Economic Research Journal, p. 4-19. Kalina Manova and Zhiwei Zhang (2012), Export Prices across Firms and Destinations, Quarterly Journal of Economics 127 (2012), p.379-436. Xiao Gang (12 October 2012), Regulating shadow banking, China Daily. Zhiwei Zhang (November 2001), Speculative Attaches in the Asia Crisis, IMF Working Paper Series, WP/01/189.
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